In the financial sector, an index is a statistical indicator providing a representation of the value of the securities which constitute the index. They are commonly used to serve as barometers for a given market or industry. In that connection, indices are commonly used as benchmarks against which financial or economic performance is measured, such as the performance of an investment fund (such as a mutual fund or pension fund). As the number and diversity of the investment processes of funds have grown, there is a need for indices that can more reliably measure the performance of the various funds.
Currently there exist three general approaches for such indices: the fixed-percentile approach, the fixed-number-of-companies approach, and the fixed-market-cap-cutoff approach. In the fixed-percentile approach, the constituents of an index typically include the publicly traded companies that make up a certain percentage of a given market or sector by market capitalization. For example, for a large capitalization market segment, the index may include the top 70-85% by market capitalization, a mid-cap segment may include the next 15%, and a small-cap segment may include the next 13% (the bottom 2% or so may be excluded because of illiquidity). The percentile cutoffs can be applied at a country or regional level. Examples of global indices using a fixed-percentile approach are the S&P/Citigroup Global Equity Indices and the FTSE Global Equity Indices.
International equity indices based on the percentile approach provide the benefit of consistent country representation; each country's weight reflects the proportional size of its market, and each country's weight is identical across size composites. However, the fixed-percentile approach offers very little size integrity within each size segment. For example, for a large cap index with 85% coverage, the company at the 85th percentile in one country may have a market capitalization of USD 3 billion, but the company at the 85th percentile in another country may only have a market capitalization of USD 0.9 billion. In addition, there may be poor index stability in a fixed-percentile index as the number of companies in the index may vary greatly over time, as shown in the example in FIG. 1. This figure shows that the number of companies covering 85% of the market capitalization of the U.S. market varied from between about 500 and 900 companies for the years 1992 to 2003.
In the fixed-number-of-companies approach, the number of constituent companies in the index is fixed. For example, in the U.S., the top 750 companies by capitalization could be chosen to depict the large and mid-cap market segments, with the next 1750 forming the small-cap segment, and together the 2500 companies comprising the investable market index. Examples of fixed-number-of-companies indices are the Russell 2000, the Dow Jones Industrial Average, and the S&P 500 Equity Index. An example of a global fixed-number-of-companies index is the S&P Global 1200 and the Dow Jones STOXX Global 1800 Index. The S&P Global 1200 is an aggregation of seven country/regional S&P indices capturing approximately 70% of the world equity market capitalization.
Fixed-number-of-companies indices provide good index stability and low turnover. But both country representation and size cutoffs may vary widely over time. FIG. 2 shows the percentile market cap coverage for the top 750 companies in the U.S. from 1992 to 2003. As can be seen, the percentile market cap coverage varied from about 82% to 90% in this time period. And this is just for one country. Similar—or even more extreme—variations may exist in other countries that are part of a global fixed-number-of-companies index for the same time period.
In the fixed-market-cap-cutoff approach, size segments in the indices are based on a fixed market capitalization level. For example, a USD 2 billion cutoff could be used to define large and mid-cap companies, while companies below that level, but with a capitalization of at least USD 200 million, could be included in a small-cap index. An example of a suite of global fixed-market-cap-cutoff indices is the S&P/Citigroup Cap Range Indices. An advantage of fixed-market-cap-cutoff indices is that they provide near perfect size integrity—every constituent company in the index meets the market-cap cutoffs. A potential drawback of fixed-market-cap-cutoff indices is that they sometimes provide varying country composition within a size segment, as shown in the example of FIG. 3. This chart depicts the market capitalization percentile coverage for companies having a market capitalization of USD 2 billion or greater for a number of countries. As can been seen, the percentile coverages of the different countries vary from 57% to 92%.
As index needs of investors seeking international diversification have evolved over time, new indices utilizing one of the three general approaches have been created. In response to investor needs for size segment representation, MSCI (Morgan Stanley Capital International) introduced the International Small-cap index in 1998 and increased the targeted coverage of the Standard indices to 85% from 60%. The MSCI International Small-cap index targets 40% coverage of the float market capitalization of companies in the full market capitalization size range from $200 million to $1.5 billion.
Meaningful changes in international investing (such as increased liquidity, greater access to international markets, increased sophistication and specialization of asset managers and owners, and shifts from individual national markets to regional markets) continue to occur. In addition, the recent performance disparities across different segments of the international financial markets has led investors to seek the ability to focus on specific size (e.g., large-, mid-, small-cap) and style (e.g., value, growth, etc.) segments of the market, as well as the performance of the entire opportunity set (since missing some segments may affect the overall performance of the portfolio). Since the current state of the art applies only one approach in index construction—percentile, number of companies, or US dollar cutoff—current indices cannot address all the needs of investors who desire deeper coverage and granular segmentation without sacrificing index stability, size integrity, and consistent country representation. Indices that provide broader coverage (i.e., more companies covering more of each market) and that allow for meaningful size and style segmentation are needed to address these changing circumstances.